Alan Greenspan, Wizard or Villian?

June 27, 2005

By Christopher Farrell Remember when Federal Reserve Board Chairman Alan Greenspan held sway over the American economy -- and imagination? "By the dawn of the new millennium, it was nearly impossible to find anyone in America who wasn't gaga over Greenspan," writes Justin Martin in Greenspan: The Man Behind Money. "Democrats and Republicans, Wall Street, and Main Street, dogs and cats -- all were high on the Fed chairman."

No more. Greenspan-bashing is now a popular sport among the Masters of the Universe. One reason is that the 10-year economic expansion came to an end with the dot-com bust and subsequent recession. Another is that Greenspan's standing as the Monetary Maestro was overhyped during the halcyon days of the 1990s. And the third is that his fallibility as a central banker was overemphasized during the difficult economy of the early 2000s. Indeed, the chairman has never recovered his lost luster.

Still, Greenspan's most vehement critics go a lot further than this. They're convinced he has made a fundamental error as a monetary economist. Call it the hairshirt economists vs. the cheerleaders for growth-is-good. The hairshirts believe that for the health of the economy to be restored, the inevitable bust that follows a boom must be at least as great as the boom. Growth proponents -- and there's none greater than Greenspan -- believe that it's better to limit the fallout of a bust and get the economy growing again as quickly as possible.

WORST-CASE SCENARIO. To the hairshirts' way of thinking, the great mistake Greenspan made was not allowing for a vicious economic and financial downturn to purge the speculative excesses built up during the heady '90s. Instead, he convinced his colleagues to drive rates to a 45-year low to limit the damage from the recession. The Fed then nurtured the recovery by keeping money policy loose (until recently, that is).

The result: today's "low saving rates, the housing bubble, high debt loads, and a runaway current account deficit," writes Stephen Roach, chief economist at Morgan Stanley, in his essay "Original Sin." The critics say Greenspan has transformed the economy into a giant bubble, concocting one even greater than the one that already burst. The longer he delays the day of reckoning, the worse the fallout will be when the bubble pops.

That's a severe indictment -- but not necessarily a valid one. A problem with the anti-Greenspan mindset is that hairshirt economics was largely discredited during the Great Depression. The most infamous proponent of this point of view was Andrew Mellon, President Herbert Hoover's Treasury Secretary. He called for letting the Depression run its course without government interference: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," he remarked. Doing so would "purge the rottenness out of the system."

GROWTH IS GOOD. Mellon was far from alone in valuing severe downturns as purgatives. The depression-is-desirable crowd included such legendary economists as Joseph Schumpeter, Friedrich Hayek, and Lionel Robbins, according to University of California at Berkeley economist J. Brad DeLong in his essay "'Liquidation' Cycles and the Great Depression."

Mainstream economists of all schools, from Keynesianism to monetarism, turned away from hairshirt economics after the Great Depression. They realized that the government could play a positive role in counteracting contractionary forces in the economy. Since then, Washington has been comfortable using the levers of fiscal and monetary policy to limit the economy's downward trajectory during recessions.

But Greenspan goes further. Despite his dour demeanor during periodic congressional testimony, he's fundamentally an economic optimist. His speeches are laced with references to innovation and risk-taking, the wellsprings of economic growth. In essence, Greenspan realizes that growth is good for the economics of discovery.

A WINNING BET. Case in point: The chairmanan came under heavy criticism during the 1990s for not "taking the punchbowl away" when the economy picked up steam and the unemployment rate fell. The fear among most economists was that inflation would take off as the economy heated up. But Greenspan gambled that in a global, high-tech economy inflation wouldn't ignite because competitive pressures were forcing business to become more efficient, boosting productivity. The bet paid off handsomely.

American productivity has been running at an average annual rate of 3% since 1995, about double the pace of the previous two decades. Productivity is what economists really care about, because its growth rate is the foundation of higher living standards. "Without a punchbowl to enjoy, there will be no innovation, no technological change, no rise in living standards, no dreams of a brighter future -- which include a home of one's own," says Peter Bernstein, a New York financial economist and adviser to endowments and other institutions.

Indeed, most economists systematically overestimate the limits to growth and underestimate the extent of the possible. Nobel laureate Robert Forgel points out that since the end of World War II, there have been wide-ranging debates about future developments and that the forecasts of mainstream economists were uniformly too pessimistic. For instance, economists focused on the likelihood of secular stagnation after World War II even during the "Golden Age" of economic expansion.

FUTURE SHOCK. Alarms sounded during the late 1960s and early 1970s about rapid population growth smothering less-developed countries even while fertility rates in the Third World began to decline rapidly. The extraordinary economic growth in Southeast and East Asia were largely unforeseen. Fogel archly suggests you might be better off paying more attention to the prognostications of science-fiction writers than economists.

Perhaps there is a bubble in the housing market. Certainly, home prices have strayed far from fundamental values on both coasts. The popularity of interest-only mortgages and other speculative financing techniques is worrisome (see BW Online, 6/16/05, "The Mortgage Trap"). But a record 70% of American households now own their own homes. And growth is also persuading business leaders to invest in new high-tech gear and venture capitalists to back innovation in everything from fuel-efficient engines to nanotechnology.

Look, Greenspan is no economic wizard, and this isn't a brief to defend him. He has made his share of mistakes, although fewer than many of his predecessors. But what should be defended is the economics of growth. Remember, not all price increases are bubbles, booms are better than busts, and growth is not only good -- it's vital. Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online